What is IRR (Internal Rate of Return)?

IRR stands for Internal Rate of Return. The IRR helps measure if a potential investment is going to be profitable in the capital budgeting process.

In general, the higher the IRR, the better the investment looks. This is to say that IRR runs across the board for investments and allows firms to rank investments relative to each other.

Ceteris paribus, with other conditions being the same, the project that has the highest IRR will probably be the project that a firm wants to invest in first.

One may also hear Internal Rate of Return referred to as “Economic Rate of Return” (ERR).

How to Use the Formula

The IRR is reliant on the same calculations of Net Present Value (NPV). This is because IRR is a discount rate equivalent to setting the cash flows from a project equal to zero; essentially just set NPV to zero and solve.

Below is the formula for NPV.

where:

Ct = net cash inflow during the period t

Co= total initial investment costs

r = discount rate

t = number of time periods

In order to calculate IRR from the above equation, make NPV equal to zero and solve for the discount rate (r).

Sadly, in a practical sense, IRR is not easily calculated from an analytical standpoint by hand. It is much easier to do it in a computer program that is equipped to handle this equation or by trial and error.

Example of IRR In Action

Assume there are two projects that a company is reviewing. Management must decide whether to move forward with one, none or both of the projects. The cash flow patterns for each project are as follows

Project A

Initial Outlay = $5,000

Year one = $1,700

Year two = $1,900

Year three = $1,600

Year four = $1,500

Year five = $700

Project B

Initial Outlay = $2,000

Year one = $400

Year two = $700

Year three = $500

Year four = $400

Year five = $300

The IRR for each project must be calculated. This is through an iterative process, solving for IRR in the following equation:

$0 = (initial outlay x -1) + CF1 / (1 + IRR) ^ 1 + CF2 / (1 + IRR) ^ 2 + … + CFX / (1 + IRR) ^ X

Using the above examples, the IRR for each project is calculated as:

IRR Project A: $0 = (-$5,000) + $1,700 / (1 + IRR) ^ 1 + $1,900 / (1 + IRR) ^ 2 + $1,600 / (1 + IRR) ^ 3 + $1,500 / (1 + IRR) ^ 4 + $700 / (1 + IRR) ^ 5

IRR Project B: $0 = (-$2,000) + $400 / (1 + IRR) ^ 1 + $700 / (1 + IRR) ^ 2 + $500 / (1 + IRR) ^ 3 + $400 / (1 + IRR) ^ 4 + $300 / (1 + IRR) ^ 5

IRR Project A = 16.61%

IRR Project B = 5.23%

If the company’s cost of capital is 10%, management should proceed with Project A and reject Project B.

Why a Company Should Care about IRR?

From a theoretical standpoint, if the IRR is greater than the cost of capital, the project is profitable. Firms are supposed to be profit-maximizers so if the above is the case, the firm should undertake the investment in the project.

However, while planning out projects, firms will often establish a Required Rate of Return (RRR) which will determine the minimum percentage return that a firm is willing to accept on a project. Basically, the firm is establishing if a project is worthwhile.

When comparing projects, companies tend to embark on projects where the variance between IRR and RRR is greatest, only on the positive side.

In the securities market, the IRRs can be analyzed against the going Rates of Return. Meaning, if a firm is struggling to find a project that has a desirable IRR, the firm can simply dump its retained earnings into the actual market.

IRR seems to be an eye-catching metric, but it should always be used in connection with NPV. Using it in conjunction with NPV, will provide a clearer picture as to whether a firm should invest because the firm will be able to see the value in the potential investment.

Without combining IRR and NPV looks, a company may be missing the potential to add an ample amount of value to the company. For example, a project may have a high NPV, but a low IRR. This means that the company may only see slow returns, but those returns could be in a large amount.

An issue also rises when comparing projects of different lengths; It is important to see the overall picture. Let’s say there is a short project with a high IRR that means that using IRR alone makes this project seem like a no-brainer. However, what if the project has a low NPV? Firms must play the long and short game.

Lastly, be careful when attempting to calculate IRR. There is a very common misuse of IRR. If it is miscalculated, it can lead to a multitude of problems such as the belief that a project is bringing in more money than it actually is; it is not as profitable as once thought to be.

  1. http://www.investopedia.com/terms/i/internal-rate-of-return-rule.asp
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